Reducing Your Taxable Estate

While most families currently don’t have to worry about facing estate taxes upon death, those who were subject to the tax in 2020 paid an estimated $16 billion in estate taxes. If you’re fortunate enough to have an estate that might be subject to the estate tax, there are steps you can take to reduce your taxes. The following methods are just some of the ways to move assets out of your taxable estate.

The Annual Gift Tax Exclusion

Federal law allows you to gift up to $15,000 in cash or assets to someone in 2021 without having to worry about paying a gift tax. That limit is per person, not the sum total of your gifts, so you can gift up to $15,000 to as many people as you want. That’s one way that you can begin the orderly distribution of your estate while you are still alive and reduce your taxable estate. In addition, if you are married, you and your spouse can elect to split a gift, which means that the two of you together can gift $30,000 to one recipient. While you don’t need to pay gift tax on the sum, if you choose to split a gift, you do have to file a gift tax return.

The Lifetime Gift Exemption

In addition to the annual gift tax exclusion, the lifetime gift tax exemption in 2021 of $11.7 million allows you to gift beyond $15,000 to an individual without paying gift tax. What that means is that, when done properly, you could gift someone $11.715 million in 2021 and not have to pay any gift taxes on the transfer. You do need to file a gift tax return, though, and the amount above the annual gift tax exclusion reduces the value of your estate tax exemption (both are the same amount), dollar for dollar.

If the lifetime gift tax exemption and the estate tax exemption are the same amount, does it matter whether you gift when you’re alive as opposed to passing on assets after death? Yes! At the end of 2025, the estate tax exemption is slated to drop back to what it was prior to 2018. However, even if the exemption drops, the IRS has decided there will be no clawback on lifetime gifts. You could use your entire $11.7 million lifetime gift tax exemption in 2021, and if that exemption dropped to $6 million in 2026, you wouldn’t owe any gift tax on the amount you had already given. If you waited until 2026 to begin transferring assets (whether through giving or death), the threshold before paying gift or estate taxes would be much lower than it currently is.

Sometimes the question arises about what type of assets you should gift to someone. The best method is to gift appreciating assets (those expected to go up in value). By gifting an asset (such as property or stock) expected to increase in value, you are able to remove future appreciation from your estate while taking advantage of the asset’s current lower value. This can be particularly helpful if you begin your estate planning early.

Grantor Retained Trusts

Grantor retained trusts are irrevocable trusts that are used to transfer assets from one family member to another (or some other loved one) over time while retaining an income stream for the grantor during the trust term. The income stream can be in the form of an income interest, an annuity payment, or a unitrust payment. The value of the gift to the beneficiary is determined by reducing the fair market value of the donated property by the value of the retained interest or income stream. This technique allows for the transfer of an asset at a discounted gift tax value, since the beneficiary does not receive the property until the end of the trust term, and the technique removes the future appreciation of the asset from the grantor’s estate.

Some common grantor retained trusts include grantor retained income trusts (GRIT), in which an income interest is retained by the grantor for the term of the trust, grantor retained annuity trusts (GRAT), in which a fixed annuity is paid to the grantor for a defined term, and grantor retained unitrusts (GRUT), in which a fixed percentage of the trust’s assets are paid each year to the grantor. GRUTs are used less frequently than GRITs and GRATs because of the costs associated with revaluing the trust’s assets each year, as well the possibility that a quickly appreciating asset would cause annual payments to the grantor to increase each year, defeating the objective of lowering the grantor’s gross estate.

Qualified Personal Residence Trust

A qualified personal residence trust (QPRT) is a special form of a GRIT. The grantor contributes a personal residence to a trust and instead of receiving the trust income, the grantor receives use of the personal residence as the income component. At the end of the trust term, the residence passes to the remaindermen, and if the grantor is still living, he may then lease (at fair market value) the property from the remaindermen and continue to use it as his personal residence.

The original transfer of the residence is treated as a gift to the extent that the fair market value of the residence exceeds the present value of the grantor’s retained interest. This is an excellent transfer device when the personal residence is appreciating at a high rate and there is an intent to keep the property in the family for the long-term. The value of the personal residence is frozen for estate tax purposes.

The Family Limited Partnership

A family limited partnership (FLP) is a limited partnership created under state law with the primary purpose of transferring assets to younger generations using valuation discounts. To avoid IRS contestation of the FLP arrangement, the FLP should possess economic substance by having its own checking accounts, tax identification number, payroll, and should not allow family members to withdraw funds at will. There should be a reason for the creation of the partnership, and not just a means to pass along assets.

For a family limited partnership, highly appreciating property is transferred to a limited partnership in return for both 1% general and 99% limited partnership interests. Once the FLP is created, the owner of the general and limited partnership interests values the limited partnership interests. Because there are usually transfer restrictions on the limited partnership interests and the limited partners have little control of the management of the partnership, the limited partnership shares are usually valued at a 20%-40% discount. The grantor can then begin an annual gifting program using the discounts and the gift tax annual exclusion to transfer limited partnership interests to younger generation family members at reduced transfer costs.

The key to reducing your taxable estate is starting early. The earlier you begin, the more time you have to effectively transfer assets and avoid estate taxes. Then, you can rest comfortably knowing that what you’ve worked your whole life for is protected.

About Chase Investment Counsel

Chase Investment Counsel is a family and employee-owned boutique wealth management firm that offers personalized investment services. Our clients include career professionals, those nearing or in retirement, and families experiencing financial transitions such as generational wealth transfer, widowhood, divorce or sale of a business. Chase’s active, disciplined investment management team is focused on selecting individual stocks and bonds targeted to each investor’s specific financial goals and risk tolerance. Established in 1957 in Charlottesville, VA, Chase Investment Counsel manages approximately $300 million in assets.

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